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Management

The changing face of share plans

Tuesday, 05 December 2006

Share plans have been subjected to various tax and accounting changes, which have significantly affected how they operate. Linda Giles, Manager of Client Services at Share Option Centre Ltd, reports on the consequences for businesses and employees.

The wider use of share plans as a means of rewarding staff has increased in the last few years. In addition, there have been a vast number of tax and accounting changes affecting share plans. This has introduced more complexity, and impacts how share plans are operated and reported, and some of the changes have a financial implication for companies and employees.

There will be far-reaching consequences for companies when the International Accounting Standards Board (IASB) proposals to expense share options become a reality. The UK Accounting Standards Board (ASB) supports the basic principle and has issued UK standard FRED 31. The proposals are expected to come into effect for accounting years after 1 January 2004.

With regard to the tax treatment of options, there were a number of measures announced in the Budget that are now detailed in the new Finance Act 2003. There are also more stringent reporting requirements as outlined in the DTI Directors’ Remuneration Reporting Regulations.

IASB proposals to expense options

The main principle behind the IASB proposals is that currently a company’s expenses are viewed as understated and profits overstated without the inclusion of share options as an expense.

The IASB proposals mean that share options and awards will create a charge to the company profit and loss account. At present, there is only a reduction in company profits if the option or award is granted at a discount. The key points are that the fair value of an option or award should be determined on date of grant, ie when the goods are received or consumed. All employee share plans, including Save As You Earn are affected by the IASB Proposals.

The fair value will be calculated using an option pricing model and there will be extensive disclosure requirements. There is no specification about what model should be used. Black Scholes, a model that is more appropriate for traded options, has been suggested as a possibility. However, unlike traded options, employee options are not transferable. If Black Scholes were to be used, adjustments would need to be made to arrive at a fair value for an employee share option. Another alternative would be an expectation model or value time risk model to take into account the expectation of employees of the price of share in the future. Companies should disclose the type of model used, key assumptions and other information about how the fair value has been measured in the Annual Accounts.

Only options or awards granted prior to 7 November 2002 are exempt from the new accounting treatment, but if the options or awards were granted after 7 November 2002, but vest before the new rules come into force, they too can be exempted.

The IASB is currently making decisions on exactly how the option valuation will be derived. Factors that will need to be considered in any option-pricing model will include:

Exercise price of the option or award;
Expected life of the option;
Expected volatility of the share price;
Dividends expected on the shares;
Risk-free interest rate;
Forfeiture (ie the likelihood of some options or awards lapsing);
The likelihood of performance condition satisfaction.

The re-pricing of options should be recognised as a new grant date.

Data management requirements for IASB proposals

As soon as IASB proposals come into force, it is essential that companies ensure that robust systems are in place to manage the additional administrative requirements that expensing options will create. The Finance department will need to liaise with whoever is responsible for the administration of the company’s share plans to ensure the information is provided in the required format to facilitate the calculation of the fair value of the options.

Key points to bear in mind are:

The share plan data should be held in a flexible way so that information can be extracted from various levels. This is particularly important where there are phased vesting options, as the option life is one of the key pieces of data required for the option pricing model.
Share plan data should be kept updated, as there will be an impact on the income statement if incorrect option prices or dates of grant etc, are used.
It will be vital to keep accurate and centrally held information on performance conditions attached to options as this will have an impact on the option pricing model.

Finance Act 2003

The Finance Act 2003 was enacted in July 2003 and included a number of measures affecting the tax treatment of options. Amongst the changes was a new obligation on companies to withhold income tax on certain transactions and a new NICs charge.

Companies should ensure that any potential increase in NICs is duly considered and decisions made about whether this should be transferred to employees or not. From an administrative perspective, the options database and procedures for exercise of options should be amended to reflect the changes to tax treatment.

Corporation tax relief

A new statutory corporation tax (CT) relief on the cost of providing shares under employee share plans has been introduced. The CT deduction is available to companies who have employee share plans under which the employees are subject to UK tax on the award of shares. This would also apply if the shares were obtained under an Inland Revenue approved scheme or Enterprise Management Incentive Scheme. This avoids the need for companies to set up trusts to generate a CT deduction for the cost of the shares.

The Directors’ Remuneration Report Regulations

These came into force on August 2002 for financial years ending on or after 31 December 2002. The regulations cover quoted companies, although AIM listed companies are excluded. The DTI introduced the new regulations in part to bridge the gap in compliance with the Greenbury recommendations on the disclosure of remuneration policy.

Practical implications

The requirement is that the separate report must be approved by the board of directors, signed and filed at Companies House.

The report should include:

Details of performance targets for LTIPs and Executive Share Option Plans.
An explanation of the company’s share plans and the relationship between performance targets and the company’s long-term objectives.
Where there is a comparison of the performance conditions with other companies or indices, the companies and/or indices should be disclosed.
A performance graph measuring historical company performance against a broad equity market should be produced and a graph showing a company’s total shareholder return relative to a group of companies.
An explanation should be provided of why the performance conditions were chosen and a summary of the methods used to assess their achievement.

There is little doubt that the changes and additional reporting requirements, in both accounting and tax regulations, will result in a significantly increased workload for the finance function. It is therefore essential that careful thought be given to the existing accounting and administrative systems. Furthermore resources should be made available to ensure that employee share plans remain compliant and are robust enough to accommodate future changes to tax and accountancy treatment. This will include regularly updating relevant departments on what information is needed to ensure that the correct disclosures and payments are made, thus ensuring the company is not exposed to the penalties that will inevitably follow from a failure to comply.

(This article was originally published in Director of Finance 2004 edition)